Following the monthly issuance of FGN savings bond by the government as a means to make the Nigerian bond market accessible to retail investors, a lot of people have been asking whether to invest in such savings bonds or to invest in money market or bond funds instead.
That question of choice of investment type is not out of place. One of the processes of investment, having determined one’s risk tolerance and investment time horizon, is to decide on asset allocation. Asset allocation decision entails choosing between different available investment types or a combination thereof.
So, this question falls within the ambit of asset allocation decision making. To be able to choose, one needs to know what each of the available asset classes or investment types are and what their characteristics are. You would not want to choose the unknown, which will be akin to shooting in the dark. So, the first step is a good understanding of the investment types, their features and what they offer both in terms of risk and returns.
A bond, and in this case, a savings bond is a debt obligation, like an IOU, issued by an entity, in this case, the federal government. When you buy the FGN savings bond, you are lending money to the government in return for a piece of paper, an IOU, that acknowledges that you have lent the government a specified amount for a specified period.
In exchange for the loan, the federal government will pay you interest at stated intervals, usually every three months, and at maturity, you will receive the amount you lent to the government back. The interest payment incidental to a bond is contractual and obligatory on the borrower, (the government) and non-payment constitutes an enforceable or actionable breach of contract that could even lead to bankruptcy, in extreme cases.
On the other hand, a bond fund is a mutual fund that invests in bonds. When you invest in bond funds, you are indirectly invested in the bonds that make up the basket called XYZ bond fund. When you invest in a savings bond, for example, you are most likely going to invest in just one or two of such bonds, but when you invest in a bond fund, you are invested in all the bonds that make up the bond fund, and that is where diversification comes into play. Should you want to invest in as many bonds as contained in a bond fund, you will need to invest lots of money.
Money market funds are like bond funds, only that they invest in short term fixed income securities like treasury bills, commercial papers or even savings bonds. Again, you are not investing directly in the constituent investments, but indirectly through the money market fund.
When you invest in a bond, or savings bond, you are almost guaranteed that you will receive your principal back at maturity as long as you hold it to maturity, unless the issuer defaults through bankruptcy. That is the credit risk characteristic of a bond. Since it is FGN savings bond, the probability of default is very remote.
Investment in a bond fund or money market fund does not guarantee a fixed interest payment, rather, the interest fluctuates according to market conditions which have an effect on the performance of the bond fund.
Again, the prices of bond funds are based on the prices of the underlying bonds contained in the basket, such that, if prices of the bonds fall, the Net Asset Value (NAV) of the bond fund will also fall. In that case, you may lose part or all your principal investment in the bond fund, depending on the extent of decline in prices.
This, therefore, means that bond funds and money market funds carry more risk than direct savings bond investment. The other side of the coin is that when you invest in bond funds, you have the opportunity to receive much more than your principal investment if prices keep going up and the fund’s NAV is on the increase. That upside potential is the compensation for the additional risk taken by investing in bond funds.
Which Type should you Invest In?
There is no absolute answer to the quest as it depends on some factors that are investor specific. The major determinant of which one to buy or invest in should be your risk tolerance profile, investment time horizon, and the amount of money available to you.
If you are willing to bear the added risk, then bond mutual funds might be a better choice especially if you expect the interest rate to decline within your investment time horizon. This is because bond prices increase when interest rates fall.
In that case, bond funds’ NAV rise when interest rates fall thereby giving the bond fund investor more capital gain or capital appreciation. But unfortunately, that gain could be eroded if interest rates begin to go up because at that point in time, bond prices will fall and so will the resulting NAV from bond funds.
What this implies is that, if you expect interest rate to rise, it will be better to buy savings bonds or invest in money market funds rather than bond mutual funds whose prices fall with rising interest rate. By so doing, you will enjoy the regular interest payment on bonds and be sure to receive your principal from the government at maturity.
Diversification is the Key
Depending on your investable funds, the best bet is to diversify by splitting your investment between FGN savings bonds, money market mutual funds and bond funds so that you hedge against falling and rising interest rates or other economic circumstances and end up having the best of both worlds.